Convertible debt under asymmetric information and agency problems, a solution to the convertible debt puzzle

Graduate Schoo, E TD F e n * 9

PURDUE UNIVERSITY
GRADUATE SCHOOL
Thesis Acceptance

This is to certify that the thesis prepared

By Fernando R. Diaz
Entitled Convertible Bonds Under Asymmetric Information and Agency Problems: A

Solution to the Convertible Debt Puzzle

Complies with University regulations and meets the standards of the Graduate School for originality
and quality

Doctor of Philosophy

For the degree o f _____________________

Final examining committee members

David J. Denis

Co-

.

_____________________________________________________ , C h a ir

Rodolfo Martell

Co-Chair

P. Raghavendra Rau

John J. McConnell

Approved by Major Professor(s):

Dav*d J- Denis

Approved by Head o f Graduate Program:

Jack Barron______________

Date of Graduate Program Head's Approval:

02/19/2007

Reproduced with permission of the copyright owner. Further reproduction prohibited without permission.


Reproduced with permission of the copyright owner. Further reproduction prohibited without permission.


C O N V E R T IB L E D E B T U N D E R A S Y M M E T R IC IN F O R M A T IO N A N D A G E N C Y
P R O B LE M S : A S O L U T IO N T O T H E C O N V E R T IB L E D E B T PU ZZLE

A Thesis
Submitted to the Faculty

of
Purdue University
by
Fernando Diaz

In Partial Fulfillment of the
Requirem ents for the Degree
of
Doctor of Philosophy

M ay 20 0 7
Purdue University
W est Lafayette, Indiana
r ~ " ' V . . - '

Reproduced with permission of the copyright owner. Further reproduction prohibited without permission.


UMI Number: 3278668

INFORMATION TO USERS

The quality of this reproduction is dependent upon the quality of the copy
submitted. Broken or indistinct print, colored or poor quality illustrations and
photographs, print bleed-through, substandard margins, and improper
alignment can adversely affect reproduction.
In the unlikely event that the author did not send a complete manuscript
and there are missing pages, these will be noted. Also, if unauthorized
copyright material had to be removed, a note will indicate the deletion.

®

UMI
UMI Microform 3278668
Copyright 2007 by ProQuest Information and Learning Company.
All rights reserved. This microform edition is protected against
unauthorized copying under Title 17, United States Code.

ProQuest Information and Learning Company
300 North Zeeb Road
P.O. Box 1346
Ann Arbor, Ml 48106-1346

Reproduced with permission of the copyright owner. Further reproduction prohibited without permission.


ACKNOWLEDGMENTS

The author would like to thank Sonya Lim and John Barron who read early
versions of this thesis and made important suggestions to improve it. This work
has also benefited from conversations with Sandipan Mullick and M atthew Cain. I
am particularly grateful to Jason Abrevaya, Mike Cooper, David Denis, Rodolfo
Martell, John McConnell, and Raghu Rau for their valuable comments and
feedback.

Reproduced with permission of the copyright owner. Further reproduction prohibited without permission.


TABLE OF CONTENTS

P age
LIST O F T A B L E S ........................................................................................................................v
LIST O F F IG U R E S ................................................................................................................... vi
A B S T R A C T .................................................................................................................................vii
C H A P T E R 1. Introduction........................................................................................................1
C H A P T E R 2. Literature R eview .............................................................................................7
2.1. Use of Convertible D e b t............................................................................................... 7
2.2. Stock price reactions to announcements of convertible issues.....................11
2.3. Stock price reactions to announcements of redem ption .................................13
2.4. Relation to Prior Literature........................................................................................ 16
C H A P T E R 3. A Non technical overview of the M o d e l.................................................20
C H A P T E R 4. A Bayesian Model of Asymmetric Inform ation.................................... 2 4
4.1. The Basic M o d e l.......................................................................................................... 2 4
4.2. The Model Augmented with Agency P ro b le m s..................................................2 7
C H A P T E R 5. Data description and M eth odology......................................................... 41
C H A P T E R 6. Empirical R esults.......................................................................................... 48
6.1. M arket Reaction at the Issuance D a te ..................................................................48
6.2. Market Reaction at the Redemption D a te ............................................................57
6.3. Relation between the first and second dates of the m odel............................. 66
6.4. Liquidity........................................................................................................................... 70
C H A P T E R 7. Conclusions.................................................................................................... 72
R E F E R E N C E S .........................................................................................................................74
A P P E N D IX ............................................................................................................................... 103
V IT A ............................................................................................................................................112

c
Reproduced with permission of the copyright owner. Further reproduction prohibited without permission.


V

LIST O F TABLES

Table
P age
Table 1. Descriptive Statistics............................................................................................. 77
Table 2. M arket Reaction at Issuance Announcement D a y........................................79
Table 3. Relation between CARs at Issuance Announcem ent Day and proxy
variables for Agency Problems and Firms’ V a lu e ...................................................80
Table 4. Relation between CARs at Issuance Announcem ent Day, Agency
Problems and Insiders’ Ownership..............................................................................83
Table 5. Industry Adjusted Capital Expenditures to Assets and Industry Adjusted
q-R atio..................................................................................................................................8 4
Table 6. Regression for Below and Above Sam ple Median Industry Adjusted qRatio...................................................................................................................................... 85
Table 7. M arket Reaction at the Issuance Announcem ent Day versus Market
Reactions at the Call Announcement Day for Bonds which Conversion
Options is In the M oney.................................................................................................. 86
Table 8. Relation between CA Rs at Call Announcem ent Day and proxy variables
for Firms’ T yp e................................................................................................................... 87
Table 9. Relation between CARs at Call Announcem ent Day and proxy variables
for Firms’ Type and Agency Problem s.......................................................................89
Table 10. In and Out of the M oney Conversion Option at the Call Announcem ent
D a y .........................................................................................................................................93
Table 11 Logistic Regression: Relation between proxy variables for Agency
Problems and the Probability of calling In the M oney Convertible Bonds
94
Table 12. Logistic Regression: Relation between M arket Reactions at the
Issuance Date and the Probability of calling In the M oney Convertible Bonds.
................................................................................................................................................ 95
Table 13. Relation between Agency Conflicts at the Issuance Announcem ent

Day and Frequency of Conversion Forcing Calls. ..................................................96
Table 14. Relation between Agency Conflicts at the Issuance Announcem ent
Day and M arket Reactions to Conversion C alls......................................................97
Table 15. Liquidity Analysis...................................................................................................98
Table 16. Joint Distribution of B and y............................................................................... 99

Reproduced with permission of the copyright owner. Further reproduction prohibited without permission.


LIST O F FIG U R E S

Figure
Page
Figure 1. Timing of the Model: W ho knows w hat and w h en................................... 100
Figure 2. Values of y and a for which Truthful Revelation holds under the C S 1
contract.............................................................................................................................. 101
Figure 3. Informational Structure of the M o d el............................................................. 102

r

Reproduced with permission of the copyright owner. Further reproduction prohibited without permission.


vii

ABSTRACT

Diaz, Fernando. Ph.D., Purdue University, M ay, 200 7. Convertible Debt Under
Asymmetric Information and Agency Costs: A Solution to the Convertible Debt
Puzzle. M ajor Professors: David J. Denis and Rodolfo Martell.

I develop a model with asymmetric information and agency problems that
explains the negative stock price reactions observed when convertible bonds are
issued and w hen they are subsequently called. This model constitutes an
improvement over previous theories of convertible debt that consider these stock
price reactions separately and neglect the possibility of agency conflicts. The
empirical analysis supports the model, with firms that have a higher probability of
agency conflicts experiencing significantly m ore negative price reactions at the
offering announcem ent day. These firms also experience more adverse price
reactions when the calling of these bonds is announced. Finally, consistent with
the unified model, I docum ent a positive relation between abnormal returns at
issuance and the time elapsed between issuance and calling of convertible
bonds.

f
\

Reproduced with permission of the copyright owner. Further reproduction prohibited without permission.


1

CHAPTER 1. INTRODUCTION

A convertible bond is a corporate debt instrument, usually a junior
debenture, which can be exchanged, at the option of the holder, for a specific
number of shares of the issuing company's common stock. The amount of
equity covered by each bond is determined by the conversion ratio, which is
obtained by dividing the face value of the bond by the conversion price.
Convertible bonds are usually callable bonds. This means that the issuer has

the right to redeem the debt (for its cash value or equity equivalent) at a pre­
specified price (the call or redemption price) before the redemption date.
A large academic literature has explored the reasons for the use of
convertible securities, the type of firms that issue convertible securities, and the
effects of their issuance on the issuer’s stock price. Even though there seems
to be agreement on which types of firms issue convertible securities and on the
effects on stock price of the use of such instruments, the underlying factors that
explain these effects remain to be identified. Understanding the consequences
of the use of convertible debt becomes more important as its relevance in the
fixed income security market increases. In 2002, new issues of convertible
bonds represented the same proportion of the US corporate bond market as the
high yield sector, with an aggregate issuance value close to 15% ($92 billion) of
all new corporate issues.
Extant research has documented two different effects of these instruments
on stock price. First, there is a negative stock price reaction (around 2% ) when
(

it is announced that convertible bonds will be issued (Stein, 1992; Kim and

Reproduced with permission of the copyright owner. Further reproduction prohibited without permission.


2

Stulz, 1992).

Second, there is a negative stock market reaction to the

announcement of forced conversion of callable securities (Mikkelson, 1981;
Oferand Natarajan 1987; Asquith and Mullins, 1991).

Regarding the negative market reactions observed when firms announce
their intentions to issue convertible debt, the theoretical literature provides no
clear prediction about this reaction because of the ambiguous effects of the
trade-off between the tax and agency benefits of convertible instruments and
the potential for dilution shareholders might experience if the bonds are
converted into stock. Explanations for the negative stock market reaction to the
announcement of forced conversion of callable securities, known as the
“convertible

bonds

information

content puzzle”,

have

relied

mainly

on

information asymmetries between managers and market participants in the
context of signaling models. The puzzle arises from the fact that these negative
stock market reactions are inconsistent with the arguments put forward by
Ingersoll (1977) and Brennan and Schwartz (1977) in which conversion allows
stock holders to capture the value of the option, thus predicting a positive price
reaction.
I develop and test a model with asymmetric information and agency

problems that is capable of explaining the above described phenomena within a
unified framework. The development of such theoretical framework constitutes
an improvement over existing theories of convertible debt that consider these
phenomena separately. In the model, it is assumed that the issuers of
convertible bonds -which have empirically been shown to be high growth firms
with low ratios of tangible to total assets-, are likely to suffer from informational
asymmetries. The informational asymmetry is introduced by assuming that there
are two types of firms in the economy, low value and high value firms. In order
/

to allow for agency conflicts between insiders of the firm and outside investors, it

Reproduced with permission of the copyright owner. Further reproduction prohibited without permission.


3

is assumed that there are two types of managers, one that always behave in the
interest of current stockholders -good managers-, and one that not only cares
about the wealth of the stockholders, but also values private benefits of control bad managers.
It is shown that under a set of reasonable investors’ beliefs, the issuance of
a convertible bond generates changes in the market valuation of the stock of the
issuing company that is related to the market perceptions about firm value and
the likelihood of agency problems. Specifically, the model predicts that at the
announcement of a convertible debt offering firms more likely to have agency
conflicts and less valuable investment opportunities will experience more
negative returns. Furthermore, the model predicts that a convertible debt
contract will induce an equilibrium in which only firms that suffer from agency
problems call their bonds after the realization of bad news about firms’ value. In
this way, the model rationalizes the negative market reaction associated with

conversion-forcing calls and takes a first step towards the resolution of the
convertible debt puzzle.
To test the model, I analyze a sample of 340 bonds issued between
December, 1986 and March, 2004. For the issuance announcement day, I find
strong evidence that the in the cross-section of bond-firm observations, firms
more likely to suffer from an agency problem or more likely to be low value
firms, experience more negative stock price reactions.

In the empirical

specifications, the cumulative abnormal returns centered at the issuance
announcement day are

regressed

against common

proxies for agency

problems: the expense ratio, which exhibits negative and significant coefficients,
the sales to asset ratio, which has positive and significant coefficients, and
insiders’ ownership, which shows positive, though insignificant coefficients.
Furthermore, the specifications also control for the most likely used of the raised

Reproduced with permission of the copyright owner. Further reproduction prohibited without permission.


4

funds by including the capital expenditures to assets ratio and its interaction with

a proxy variable for agency problems - a dummy variable that distinguishes
between firms with high and low growth opportunities, which are proxied by
Tobin’s q. I find that convertible issuers that have a history of high levels of
capital expenditures and have few growth opportunities suffer significantly more
negative stock price reactions upon the issuance announcement of convertible
bonds. These results are consistent with the prediction of the model that at the
issuance announcement day stockholders of firms more likely to have agency
conflicts and/or less valuable investment opportunities will experience more
negative impacts on their shares.
The analysis of the abnormal returns at the redemption announcement
reveals that stock price reactions are consistent with the predictions of the
model. First, when firms are sorted by proxies of agency problems, I find a
significant difference of 2.35% between good (0.84% ) and bad (-1.51% )
managers when firms call their in-the-money bonds. Second, proxying for firm’s
type by the return on equity, I find that low value firms that call their in-themoney bonds experience significantly more negative returns than do high value
firms do. Finally, when abnormal returns are sorted on the moneyness of the
call embedded in the bonds I find a significant difference of almost 2% between
bonds that are out-of-the-money and those that are in-the-money, with the
former having a mean abnormal return of 0.78% and the latter o f -1.16%. These
findings are consistent with the existence of a Bayesian Separating Equilibrium
in which good managers separate from bad managers in low value states of
nature.
Incorporating agency problems into a model of asymmetric information is
essential to developing a comprehensive model. Models based only on
asymmetric information can not explain the negative market reactions observed

Reproduced with permission of the copyright owner. Further reproduction prohibited without permission.


5

at the issuance announcement day. Stein’s (1992) model, for instance, predicts
a separating equilibrium in which low value firms have no incentive to issue
convertible bonds, and these securities are issued only by firms which are
optimistic about the future. Mayers (1998, 2000) argues that convertible bonds
are the most efficient way for firms with high growth opportunities to fund a
sequence of investments of uncertain timing and value.
Also, and more importantly, these models, which neglect the possibility of
having agency problems, have not been successful in explaining the negative
market reactions associated with the redemption announcement.1 Furthermore,
Brick, Palmon, and Patro (2004) find that the cumulative abnormal returns at the
redemption announcement day are not related to common measures of
asymmetric information. In this sense, the no-agency problems case can be
considered a particular case of my model. Specifically, if the probability of
having a self serving manager is set to zero, or the value of the private benefits
of control are set to zero, then the model predicts no changes in market
valuation upon the announcement that bonds will be converted. This situation is
consistent with the lack of explanatory power of models that neglect the
possibility of agency problems.
I contribute to the literature in this area in several ways. First, my model is
the first to provide a unified explanation for the stock returns associated to the
announcement of a new offering of convertible bonds and to their subsequent
calling and conversion. Second, and in accord with the model, I show that these
stock responses are more negative for firms with a higher ex-ante likelihood of
facing agency problems and having poor growth prospects. Third, and related to
the second point, I show that incorporating agency conflicts into a model with

1 An exception is the model by Harris and Raviv (1985), who are able to rationalize the negative market
reaction to forced conversion of calls in a pure informational asymmetry framework.

Reproduced with permission of the copyright owner. Further reproduction prohibited without permission.


6

asymmetric information helps to solve the apparent inconsistency between the
predictions of these types of models and the empirical regularities associated
with convertible debt financing.
This thesis is organized as follows. Chapter 2 presents the literature review
and the place of this work in the literature. Chapter 3 provides a non technical
summary of the model. Chapter 4 presents the formal theoretical framework.
Chapter 5 presents data description and methodology. Chapter 6 presents the
empirical results. Chapter 7 concludes.

Reproduced with permission of the copyright owner. Further reproduction prohibited without permission.


7

CHAPTER 2. LITERATURE REVIEW

In this chapter, I briefly review the academic literature related to use of
convertible securities and their impact on stockholders’ interest in the firm. The
current explanations of the effects of the use of these instruments on stock
prices -

the

negative

stock

price

reaction

observed

at

the

issuance

announcement day and the subsequent negative stock price reaction at the
redemption announcement day - are analyzed from the perspective of
considering them as two separated and distinct phenomena. I argue that these
theories, even when considered as explanations of a single phenomenon, lack
power to explain the observed stock price reactions. I also discuss the relation
of my model to the existing literature, emphasizing the importance of having a
unified theory able to explain the effects of the issuance and conversion of
convertible securities.

2.1. Use of Convertible Debt

In the presence of a potential risk shifting problem, a levered firm might find
it costly to raise funds to finance new investment projects.2 Additional debt might
be too expensive or even unavailable given investors’ rational anticipation of a
risk shifting problem. Furthermore, in the context of informational asymmetries,
a stock issue might also be costly if it is considered bad news by the market

2 Black and Scholes (1973) were the first to note that the shares of a levered firm correspond to a call
option written over the value of the firm. A risk shifting problem may arise when the manager of a levered
firm, acting on behalf of her current stockholders, faces different investment projects. The convex shape of
the payoffs of levered equity provides the manager with the incentives to take excessive risks and
therefore, to invest in projects that do not maximize net present value.

Reproduced with permission of the copyright owner. Further reproduction prohibited without permission.


8

(Myers and Majluf, 1984). Green (1984) argues that convertible debt and
warrants can mitigate the incentive to take excessive risks, reversing the convex
shape of levered equity and restoring net present value maximizing incentives.
In this sense, the rationale for the use of convertible bonds is that they are less
sensitive to ex-post risk shifting than common debt.
Stein (1992) argues that convertible bonds might be used as an indirect
method for moving to a less levered capital structure when adverse selection
problems make a stock issue unattractive -i.e., the back door equity motive for
the use of convertibles. His model, an adaptation of the model in Myers and
Majluf (1984), explains two key features of the issuance of convertible bonds:
first, almost all convertible bonds are also callable bonds, which implies that
companies can force conversion. Since convertible bonds are ultimately a
portfolio of straight debt and an option to convert, it might be in the interest of
the holders of these instruments to keep their option alive as long as possible,
since if they don’t convert, they receive interest payments on the debt and keep
the value of their option. The only way for the issuing company to force
investors to exercise their conversion option early is to include a call feature in
the convertible debt contract.

Second, excessive debt can lead to financial distress. Given that financial
distress is costly, a company that is already levered and issues convertible
bonds should be signaling to the market that it is optimistic about the future. The
outcome of Stein’s model is a separating equilibrium in which low value firms do
not have the incentive to issue convertible bonds and, therefore, do not try to
mimic high value firms. Since debt holders will convert only when this action is
in their own interest, the issuing company must be expecting an increase in its
stock price, otherwise, conversion would not take place, leaving the firm with an
even larger debt burden to service.

Reproduced with permission of the copyright owner. Further reproduction prohibited without permission.


9

Stein also documents the results of surveys carried out by Pilcher (1955),
Brigham (1966) and Hoffmeister (1977) regarding the reasons firms choose to
use convertible securities. In Pilcher (1955), 82% of the surveyed managers
answered that the desire to raise common equity on a sort of delayed action
basis played the most important role in the decision to issue convertible debt. In
Brigham (1966), 73% of the surveyed managers answered that their primary
intent in issuing a convertible was to obtain equity financing. Finally, in
Hoffmeister (1977), the delayed equity motive emerged again as the single most
important.
Chakraborty and Yilmaz (2003) investigate the underinvestment problem
that arises when insiders have an informational advantage over outsiders
regarding the investment opportunity set of their firms. In the spirit of Myers and
Majluf (1984) they argue that when firm types are not observable, this will lead
to a pooling equilibrium in which securities issued by firms will be competitively
priced at their expected value, leading to dilution in the claims of firms that are

better than the average firm. Accordingly, managers behaving in the interest of
their current stockholders may choose not to invest in positive NPV projects.
However, the authors show that when the initial informational asymmetry is
solved over time, a callable convertible security solves the adverse selection
problem costlessly; i.e., there is no dilution in the claims of existing equity
holders and managers invest regardless of their private information, achieving
the symmetric information outcome. Furthermore, the bond will be called (and
converted by debt holders) after good news about the value of the firm is
received. The rationale for the use of convertible debt in this model is that the
value of callable convertible bonds is independent of the private information of
the manager and, therefore, mitigates the adverse selection problem.

Reproduced with permission of the copyright owner. Further reproduction prohibited without permission.


10

Mayers (1998, 2000) argues that convertible debt is the most cost-effective
way for corporations with large growth opportunities to finance a sequence of
investments of uncertain timing and value. The logic is the following. When a
firm has a sequence of valuable investment opportunities over time, it faces a
fundamental trade-off: if it raises the entire amount needed for the whole
sequence at once, investors might fear that their money will be misspent in the
future, regardless of the profitability of available investment opportunities.
Accordingly, they might demand terms that compensate them for bearing this
risk, which in turn increase the cost of external funds for the firm. On the other
hand, if the firm raised money only when it was needed, the issuing costs for the
entire sequence would be too high. Mayers claims that convertible bonds are
ideal for funding sequential investments in that they minimize the sum of
overinvestment and issue costs. Bondholders have the choice of converting

their bonds into equity in the future, if profitable investment opportunities do
materialize. This leaves the funds inside the company as equity, which can be
used to finance growth. On the contrary, if investment opportunities appear to
be unprofitable when the time comes to make them, bondholders will not
convert (or be forced to convert), and they will redeem their bonds instead. This
mechanism ensures that future investment options are made only if profitable,
thus controlling the over-investment problem.
Mayers analyzes nearly 300 callable convertible debt issues between 1971
and 1990. He finds that convertible issuers have higher R&D to sales ratios,
higher market to book ratios, and more volatile cash flows than their industry
counterparts. These characteristics are typical of firms with high growth options
and likely to face informational asymmetries. Korkeamaki and Moore (2004) find
strong empirical support for the Mayers’ Sequential Financing motive for
convertible debt financing and provide a satisfactory explanation to the

Reproduced with permission of the copyright owner. Further reproduction prohibited without permission.


11

differences observed in the level of call protections offered by different firms. In
particular, they find evidence that firms design the call provisions on convertible
bonds according to their need for short term financing flexibility. Moreover, they
find that the length and strength of the call protections are inversely related to
the capital expenditures of the firms in the years following the bond issuance.
In summary, the use of convertible securities has been rationalized in the
academic literature as a solution to a risk shifting or asset substitution problem
(Green, 1984), as a way to modify the capital structure of the firm in the context
of strong informational asymmetries (Stein,

1992),

as a solution to an

underinvestment problem, given the low sensitivity of the value of these
instruments to the private information of firm’s insiders (Chakraborty and Yilmaz,
2003), and as the most efficient way to finance a sequence of investments of
uncertain timing and value (Mayers, 1998, 2000).

2.2. Stock price reactions to announcements of convertible issues

The theoretical literature predicts ambiguous effects of convertible debt
issuances on stock prices, since there is a trade-off between the tax and agency
benefits of debt and the dilution effect that occurs when the bonds are converted
into stock. The empirical literature,

however, consistently finds negative

abnormal returns to the announcement of convertible bond issuances, which
suggests that the dilution effect outweighs the

debt benefits of these

instruments.3
Dann and Mikkelson (1984), Mikkelson and Partch (1986) and Eckbo (1986)
are among the first to document a significant negative abnormal return at the

3 Note that, given informational asymmetries, an adverse selection problem might also be part of the
explanation for dilution.

Reproduced with permission of the copyright owner. Further reproduction prohibited without permission.


12

initial announcement of a convertible debt offering. Stein (1992) summarizes
some results from the empirical literature documenting market reactions
between -1.3% and -2.3%. Kim and Stulz (1992) report an average abnormal
return of -1.7% for a sample of 280 convertible bond issues between 1965 and
1987.

Some

studies

document

not only a

negative

reaction

to

the

announcement of convertible bond issuances, but also report heterogeneity in
the market reactions in the cross section of firms. Dann and Mikkelson (1984)
find that the abnormal returns are less negative when the new convertible bonds

have an important impact on the increase in leverage compared to those that
have a small impact on firm leverage. More recently, Arshanapalli, Fabozzi,
Switzer, and Gosselin (2004) find that abnormal returns at the announcement of
convertible bond issuances are related to firm specific characteristics, including
market value, price to book ratio, and the size of the issue. Specifically, they find
that bigger convertible bond issues, which have a larger impact on firm’s
leverage, lead to more negative abnormal returns on the announcement days.
Their evidence supports the conjecture that that the dilution effects of future
conversion outweigh the tax benefits of short term increase in leverage. They
also find that price to book is negatively related to abnormal returns, meaning
that growth firms are more likely to be negatively affected by the announcement
of convertible debt issue. Finally, they find that larger firms experience less
negative abnormal returns. This can be interpreted as a smaller impact on the
firm’s capital structure when conversion occurs, but it is also consistent with the
view that smaller informational asymmetries are associated with less negative
market reactions.

Reproduced with permission of the copyright owner. Further reproduction prohibited without permission.


13

2.3. Stock price reactions to announcements of redemption
I

Mikkelson (1981), Ofer and Natarajan (1987), and Asquith and Mullins
(1991) are among the first papers to document significant adverse stock price
reactions to calling announcements. This phenomenon is inconsistent with the
fact that conversion transfers the value of the option from bondholders to
stockholders (Ingersoll, 1977; Brennan and Schwartz, 1977).

The efforts to explain the negative market reaction observed when firms
announce their intentions to redeem their in-the-money convertible securities,
which has become to be known as the “convertible bonds information content
puzzle” (Datta, Iskandar-Datta, and Raman, 2003), have mainly relied on
information asymmetries between managers and market participants in the
context of signaling models. Most notably, Harris and Raviv (1985) develop a
model that rationalizes the negative market reaction to conversion forcing calls.
They show that there exists an equilibrium in which managers truthfully signal
their private information by calling their convertibles if they receive unfavorable
information. In this sense, their model predicts that managers that receive
favorable information will tend to delay conversion. The authors argue that firms
that receive favorable information have lower costs of delaying conversion since
for such firms it is more likely that conversion will take place anyway.
Even though Harris and Raviv’s model rationalizes the negative abnormal
stock return associated with call announcements,

it has two

important

limitations. First, and with respect to the logic for delaying conversion, it is not
clear that bondholders will have the incentives to voluntarily convert.4 In fact,
there are situations in which voluntary conversion will not take place until the
last possible chance bondholders have to convert. Taking the extreme case in
4 Stein (1992) argues that a call feature is the only way companies have to force bondholders to exercise
their conversion option early.

Reproduced with permission of the copyright owner. Further reproduction prohibited without permission.

14

which the firm does not pay dividends, a bond holder that decides to wait until
next period to convert will get the interest payments (if any) corresponding to the
current period and benefits from the value of the option. Since the stock does
not pay dividends, she bears no costs from not converting. Accordingly, she has
no incentives to convert today, being optimal to wait until next period. Since the
same argument applies every period, bond holders will convert at their last
chance to do so. If the company pay dividends, bond holders’ optimal strategy
is to wait one period to convert if the expected interest payments for the next
period are higher that the expected dividend payment during that period. If the
dividend payments are uncertain and the interest payments are not, the same
will be true under risk neutrality. If risk aversion is assumed, an expected
interest payment lower than the expected dividend payment might make
bondholders unwilling to convert their debt, as long as dividend payments are
sufficiently more risky than interest payments.
With respect to the delayed conversion issue, Harris and Raviv predict that
managers that receive favorable information will tend to delay conversion.
Ingersoll (1976), Mikkelson (1981) and Constantinides and Grundy (1987) find
that it is not always the case that firms call convertibles as soon as the
conversion value exceeds the call price. However, Asquith (1995) demonstrates
that there is no call delay phenomenon related to convertible bonds. For a
sample of 199 bonds, issued between January 1, 1980 and December 31, 1982,
Asquith finds that most bonds, given their call protections, are called as soon as
possible. Furthermore, the median call delay for all convertible bonds is less
than four months, and if firms require a safety premium to call their bonds - i.e.,
they wait for the conversion value to exceed the call price by 20% to safely
assure it will still exceed the call price at the end of the normal 30 day call notice
period - the median delay period is less than one month.

Reproduced with permission of the copyright owner. Further reproduction prohibited without permission.


15

Chakraborty and Yilmaz (2003) investigate the reason for the use of
convertible bonds in the context of a model with asymmetric information, where
insiders of the firm are better informed about firm value than outside investors.
Assuming that the asymmetry of information is resolved over time, they show
that the value of convertible bonds is independent of manager’s private
information and that, consequently, such instruments can mitigate the adverse
selection problem and achieve the symmetric information outcome. In their
model, the convertibility and callability features of convertible debt play a central
role. Convertibility allows bondholders to choose which kind of security (debt or
equity) they will end up holding after information about firm type is disclosed,
and callability allows managers to force conversion.
In the model developed by Chakraborty and Yilmaz there is no dilution in
the claims of the existing equity holders, so managers invest regardless of their
private information. Furthermore, the bond will be called (and converted by debt
holders) only after good news about the firm is received. It is therefore difficult to
reconcile this prediction with the negative price reactions observed when firms
announce their intentions to redeem their convertible instruments.
Some studies find that the negative stock price reaction to a forced
conversion is only a transitory effect caused by selling pressure rather than a
negative signaling effect. Campbell, Ederington and Vankudre (1991) challenge
the results in Ofer and Natarajan (1987), arguing that their sample is biased.
Correcting for this bias they find that post-call cumulative abnormal returns are
not significantly negative. Mazzeo and Moore (1992), Byrd and Moore (1996)
and Ederington and Goh (2001) find that the negative stock price reaction to a
forced conversion is only a transitory effect consistent with the price pressure

hypothesis. Furthermore, and also against the signaling hypothesis, Brick, et al.
(2004) find that cumulative abnormal returns (CARs) at the redemption

Reproduced with permission of the copyright owner. Further reproduction prohibited without permission.


16

announcement day are not related to common measures of asymmetric
information.

2.4. Relation to Prior Literature

The negative market reaction observed when firms announce their intention
to issue convertible securities and the subsequent negative reaction to the early
redemption of these instruments have been treated in the existing literature as
two distinct phenomena. Furthermore, even though the convertible bonds
puzzle refers only to the observed price reaction associated with redemption
announcements, when considered together, the above described phenomena is
perhaps a more challenging puzzle for proponents of market efficiency and
investor rationality.
Arshanapalli, et al. (2004) examine a zero investment strategy aimed at
taking advantage of price variations that follow convertible debt issues. Through
simulations, they show that a strategy that takes a long position in the firm’s
convertibles bonds and a short position in the firms’ stock yields significant
profits up to 36 months after the issuance date. According to the authors, the
profitability of such strategy constitutes evidence against market efficiency.
Furthermore, since the median time elapsed between issuance and redemption
of convertible bonds is close to 3 years, it is likely that the strategy considered
by the authors covers both event dates for a large proportion of the bonds they

consider.5

This situation emphasizes the importance of considering both

phenomena under a unified analysis. If a unified theoretical framework is able to
explain the market reactions at the issuance announcement day and at the

5 For my sample of bonds, the median time elapsed between issuance announcement and redemption
announcement for bonds called in-the-money is 3.3 years.

Reproduced with permission of the copyright owner. Further reproduction prohibited without permission.